Banking on hedges

Where are the hedge fund blowups? A year ago, legislators and regulators were fretting publicly about the dangers these lightly regulated investment partnerships posed to the world's entire financial system. It appears they were looking in the wrong place.

Investors handed the industry a record $200 billion of new money to manage in 2007, a year in which hedge funds also managed to return an average of just over 10 per cent, according to Hedge Fund Research, an industry data group. That's not bad given that markets turned volatile and nasty – at least for big banks, most of which racked up billions in losses on US sub-prime mortgages, structured finance and buyout loans.

With hindsight, there are convincing reasons for the hedge funds' relative resilience that should be instructive for those still looking to wrap hedge funds in red tape.

Hedge funds are focused investment businesses. They live or die by making money for investors and their managers are directly, and handsomely, incentivised to do just that. Investment banks, by contrast, are collections of disparate businesses. Most have trading units but also have to please fee-paying clients, whose wishes can lead them to do things they feel uneasy about. It's arguably no accident that Goldman Sachs, the investment bank in the best position to pick and choose whom it does business with, is the one that has come out of last year's turmoil looking cleverest.

Hedge funds are also smaller and simpler than investment banks. Even at the biggest funds, bosses typically keep a close eye on trading and are able to identify and shut down losing trades in short order. Despite heavy losses last summer that led to its closure, industry experts have hailed quick action at Sowood Capital, the fund managed by Harvard endowment alum Jeff Larson, for preventing even bigger losses.

It helps that most hedge fund chiefs have plenty of their own cash at stake. Investment bankers are often playing with faceless shareholders' money for asymmetric rewards. Bonuses based partly on individual success are almost always going to outweigh any losses on bankers' stock holdings in a firm that has a bad year. The arrival of sovereign wealth funds to inject some $50 billion of capital into Wall Street firms like Morgan Stanley and Merrill Lynch looks like yet more of other people's money for them to bet.

Senior hedge fund types also know it's tough to start again after losing their investors' shirts. Brian Hunter, whose high-profile energy trades singed Amaranth, has tried unsuccessfully to open a new fund. Long-Term Capital Management's former ace John Meriwether made a come-back, but manages a fraction of the money he did in his glory days. There's greater anonymity in banking, unless you're a prominent chief executive or a celebrity rogue trader like Socit Gnrale's Jrme Kerviel.

Whether big hedge funds can hang onto these attributes as they get ever larger is an open question, especially for those like GLG and Och-Ziff Capital Management that are publicly traded. It's also true that some hedge funds performed poorly last year, but because they typically disclose much less than publicly-traded investment banks, their losses – and even collapses – may never attract the same level of scrutiny. Still, it's hard to believe write-offs in the billions would have escaped notice.

Investors were persuaded to hand more cash to hedge funds last year. That may well continue – the average fund may have lost nearly 2 per cent in January, but the S&P 500 was down by much more. Turbulent markets also ought, in theory, to bode well for funds, many of which claim to thrive on volatile conditions. Of course, regulators can't ignore hedge funds, which are increasingly central to financial markets. But this time at least, it's the supposedly highly-regulated banks that face a more pressing battle to restore their credibility.